With today’s low interest rates, it’s hard to generate income from a bond portfolio. “Sustained, historically low interest rates have been hampering investors’ ability to generate the level of retirement income they need,” says Dylan Tyson, president of Prudential Annuities, a unit of Newark, N.J.-based Prudential Financial. This is a particularly acute challenge, he adds, as Americans “need to fund longer retirements.”
Some financial advisors take on the problem by recommending annuities with a guaranteed lifetime income. But is that always a good idea?
Consider The Individual Situation
David Blanchett, head of retirement research at Chicago-based Morningstar, says that no single financial product is right for every situation. Advisors should consider clients’ individual needs. Those who have sufficient guaranteed income from a defined benefit pension, Social Security or something else probably don’t need payouts from an annuity.
Health and life expectancy are also relevant. Annuities can solve longevity risk—the risk that a client will outlive their retirement income sources—but that’s not worth much if they are likely to die young and have a short retirement.
“Annuities make the most sense for retirees who want that certainty from guaranteed lifetime income,” says Blanchett. They “help put the retirement strategy on autopilot. You don’t have to worry about how long you’re going to live, what the markets are doing, etc. That can be comforting for a lot of retirees.”
But there are other advantages to consider. “Annuities provide many benefits,” insists Mike Harris, senior education advisor for the Washington, D.C.-based Alliance for Lifetime Income. Among them, he cites tax deferment during a client’s accumulation years—when the account can grow tax-free until the funds are withdrawn—and payouts that can be passed on to a spouse after the annuitant’s death.
Waiting For Interest Rates To Rise
Yet even advisors who favor annuities for retirement income might be tempted to hold off till interest rates rally. Low interest rates depress annuity payouts.
The 10-year Treasury rate ended 2020 at 0.93%, a 95 basis point drop from the start of the year, according to the Secure Retirement Institute (SRI). “This has a significant impact on guaranteed living benefits,” the institute said in a press release.
But unlike bonds, annuities have the advantage of mortality pooling, sometimes called mortality credits. That means the payout amounts are derived from not just interest rates but also the life expectancy of the annuity holder at the time of purchase. Those likely to die sooner help subsidize those who live longer. That doesn’t change. So when bond yields are low, annuities are actually a better relative value.
Understanding Relative Value
Compare the average guaranteed withdrawal rate of annuities to current yields on 10-year Treasury notes. The difference, says Bryan Pinsky, senior vice president of individual retirement pricing and product development at insurance giant AIG, is “historically large.” From 2007 to 2013, the spread hovered around 200 basis points. This year, it’s between 300 and 400, favoring annuities. “Annuities can bring a tremendous value, especially in comparison to the alternatives,” says Pinsky, who is based Woodland Hills, Calif.
Another example comes from John Kennedy, head of retirement solutions distribution at Lincoln Financial Group in Radnor, Pa. “Lincoln’s income rate for a 65-year-old annuity owner 18 months ago was 5.75%, while the 10-year Treasury was 3.25%—representing a spread of 250 [basis points],” he says. “Today, our flagship annuity benefit is offering an income rate at age 65 of 5%, with the 10-year Treasury at roughly 1%. This 400 [basis point] spread represents a value proposition that is 150 [basis points] better than just 18 months ago.”
The Case Against Annuities
Others disagree. “Annuities are nothing but middlemen,” cautions Ric Edelman, founder of Edelman Financial Engines in Fairfax, Va. “When you give them your money, they invest it in the same stocks and bonds you could have bought yourself. You’ll pay large fees to have them serve as middleman, reducing your wealth.”
To be sure, annuities can be expensive, and they can tie up your money. “You kiss your money goodbye,” says Ben Barzideh, a wealth advisor at Piershale Financial Group in Barrington, Ill. Most people don’t live long enough that they’ll draw enough income from the product to get their money back, he says. Even if they do, the return on investment is poor. “Think about it like this,” he says. “If I told you to give me a big chunk of your money right now, and I’ll give it back to you in small installments over the rest of your life, and I’ll hardly add any interest to that pool of money—that doesn’t sound like something any reasonable person would do, does it? But that’s the concept of annuitization.”